Lesson 14: Normal Balances and RED Accounts
In this lesson, we will learn another facet of the double entry accounting
system. Normal balances are an important classification in financial
accounting. We've outlined the financial accounting equation and how debits and
credits come into play, now it is time to review normal balances and RED
accounts.
When you look at the accounting equation, within each element of assets,
liabilities and equity, there are a multitude of different account types. For
the purpose of this lesson, we will be discussing some of the common account
types that are used in financial accounting and how normal balances are used.
Every account maintains either credit or debit as the normal balance. The
fundamental concept is that in order to increase an account with a normal
balance of credit, the company would use a credit.
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This also works the same way with a normal balance of debit,
as a debit is used to increase the account.
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The normal balance is basically what defines whether we should credit or debit
the specific account in order to increase the balance.
Now let's look at what the normal balance is for each type of account that
falls within the accounting equation.
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The easiest way to remember this is to
think of the accounting equation as having two sides, each with a different
normal balance. The left side of assets are increased using debits while the
right side of the equation is increased by credits.
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The above graphic further demonstrates the normal balance and
whether you need to use a debit or credit to increase or decrease the account.
Assets have a normal balance of debit, meaning a debit is used to
increase the accounts. In contrast, liabilities and equities have a normal
balance of credit.
While assets, liabilities and equity are the main types of accounting elements,
there are specific types of accounts that fall into each category. Assets
involve cash, supplies, intellectual property and equipment. Liabilities
involve long term debts, accounts payable, salaries payable and taxes. Equity
accounts include common shares, preferred shares and dividends.
Take a look at the table above to
see some additional examples of each account type.
As you can see from the above acronym, RED stands for revenues, expenses and
dividends.
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Here is what each means and how the normal balances are applied.
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Revenues are
associated with equity accounts as they have an indirect relationship with
retained earnings. This simply means that when revenues increase the amount of
income that the company receives also increases. More income also translates
into more retained earnings which can either be distributed to shareholders or
kept as equity. Revenues have a normal balance of a credit. To increase the
revenue accounts, they must be credited.
Expenses are an essential part of every business as they are needed for
operations but they do lessen the income that the company receives. In contrast
of revenues, expenses lead to a reduction in income and subsequently a decrease
in retained earnings and equity. This also means that the normal balance for
expenses are a debit, because in order to increase the expense, they must be
debited.
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Dividends are the income that
is disbursed to
shareholders after taxes. When dividends are
issued, the level of retained earnings and equity is reduced because the income
is being paid out instead of kept as equity. Again, since the amount is being
reduced, the normal balance is a debit.